A financial system based on credit is just an exchange of money today for money later. I give you dollars today and temporarily lose the utility of my money in exchange for having more later. You have the inverse: the benefit of more money today and less tomorrow as you pay back the loan with interest.

This system works on trust – trust that you will pay back what you said you would pay. It is the same whether that trust is in a person, company, or government. Remove trust and it affects the credit-worthiness of an individual or company. Remove trust from a system and the entire system can unravel very quickly.

— Jeff Booth (The Price Of Tomorrow)

In the culmination of the Terra & Luna collapse, we saw the LUNA token hyper-inflate, by trying to keep the peg of the UST intact. But once the trust was gone, it was a failed attempt.

The Deterioration of the Yen

Historically, the Japanese Yen, has become known as a safe haven asset to hold in times of turbulence.

However, recently we have seen the reverse reaction, which is quite alarming:

The Japanese Yen has not only failed, to act as a safe haven, it has literally been obliterated over the recent months. Since the Ukraine invasion, it has given up about 20% against the USD. It seems like investors are losing their trust in Japan’s ability to service its debt.

Debt to GDP

This needs to be put into context to Japan’s immense debt problem:

An often mentioned study by Hirschman Capital pointed out, that out of 52 countries that reached government debt levels of over 130% of GDP, 51 ended up defaulting on the debt within the next 15 years in some way or another.

Japan is the only country which has defied this rule — so far.

Many analysts point to this as a prove that high government debt doesn’t necessarily lead to a default, but I would be cautious with that assessment. From my perspective, they first need to be able to somehow reduce their debt burden before they can claim any victory. So far, they have only shown that they were able to keep this high ratio going for more than 15 years, but the ratio keeps rising.

Lyn Alden describes the general phenomenon as follows:

To put it bluntly, when debt gets this high relative to GDP, the only way out is to default in some way. If the debt is denominated in a currency that the government can’t print (like for emerging markets with dollar-denominated debt), it eventually leads to nominal default. If the debt is denominated in a currency that they can print, it usually leads to significant devaluation of that debt via inflation, where inflation (and along with it, nominal GDP) runs much higher than interest rates for a while.

At that point, the ability to get out of inflation depends on private markets’ and policymakers’ ability to create new industrial capacity for goods and services and commodities. In other words, high levels of productivity must be re-established, or the pain continues in one form or another.

— Lyn Alden

Earlier in the year, we saw Sri Lanka unable to service its foreign debts and default. Many other developing countries also seem to be on the brink of a nominal default, as they are dealing with the aftermath effects of all the insane global Covid policies.

Japan is in a different position, since their debt is mainly denominated in Japanese Yen, which they can print.

Again, many tend to point out, that government debt is fine as long as it is owed to the own population. I think this is an erroneous way to look at it: “We owe it to ourselves” is the spirit of this thinking. But who are the “We” and who are the “ourselves”? There are either individuals or institutions behind the deal, who expect to be repaid. What difference does it make whether I lend money from my neighbor, or a friend who is living in another country? In the end, I need to pay the debt and if I don’t, the other party incurs a loss. It is the same when it comes to sovereign governments.

Furthermore, while the majority of the debt is owed to domestic investors and institutions, with 97.8% in 2021, it also has a high amount of external debt (denominated in other currencies, mainly USD), which has been rapidly rising over the past months with the falling yen.

Japan’s Budget and Fiscal Policy

Japan’s 2021 budget amounted to ¥106.6 trillion and had the following budget composition:

Social Security is the largest component, but servicing the government debt is already the second largest component and makes up more than 20% of the expenditures.

The next chart shows the government’s revenue (yellow), it’s expenditures (red) and the issuance of new debt (blue):

The trend of this chart shows the precarious position that Japan is facing. The yellow and the red line shifting further and further apart, implies that the government needs to run an increasing amount of newly issued debt. The fact that the blue bars almost touch the yellow line means that almost half of the budget is financed by new debt.

In my estimation, Japan has already entered into a debt spiral.

The total national debt is about $10,23 trillion, or ¥1,392 trillion.
At a tax revenue of about ¥60 trillion, this means that an interest rate of 4.3% would be sufficient to put the government in a position in which 100% of the tax revenue would be required to service the debt. Game over.

The JCB: Monetary Policy and Yield Curve Control

High debt is the fundamental reason why Japan has started to control the yield curve. The Japanese central bank offers to buy unlimited amounts of 10-year bonds, to cap the yield at 0.25%.

Recently, it was observable that the upper limit of the yield curve control was tested, putting the JCB’s credibility under pressure.

The question is, whether they are capable of keeping this insane monetary policy going. There are varying opinions about it:

• Some believe they will pivot, follow the tightening of other central banks and let the rates go higher.
• Others believe that they will feel the need and try their best to stick to it.
• Another theory is, that the Fed and other central banks might step in and buy Japanese debt in order to prevent global turmoil.

In any event, it remains interesting to see, how this monetary adventure will play out over the coming months.

Other Economic Considerations

Apart from the monetary and fiscal issues which Japan is facing, its economy is also underpinned by some structural problems, which make the situation look even more dire:

• Japan’s population has peaked in 2009. Its population is aging and rapidly declining. This means that the workforce will become significantly smaller over the years ahead. This has two implications:
  • A substantially higher tax burden to pay for the massive debt burden.
  • Less ability to support the elder generation and finance the rising social security expenditures (which is already the largest component in the budget).

• The energy crisis also puts tremendous pressure on Japan:
  • The country is a major energy net importer and therefore one of the countries that suffer the most from rising prices.
    • It is the 5th largest net oil importer.
    • It has no pipelines and relies totally on LNG carriers to deliver natural gas. Due to Europe’s recent endeavor, to reduce gas dependency from Russia, they are now competing for the same LNG supplies.
• The working culture: The working culture of Japan is very hierarchical and has failed to adjust over time to a new environment of international markets. According to Globis Insights:
  ”Japanese working culture is notorious for rigidity, lack of transparency, and slow decision-making. This is partly a reflection of traditional Japanese culture and its many unspoken rules. But globalization makes things even tougher.”
  This has implications for Japanese business performance. It is not anymore the vibrant and innovative economy that it used to be in the 80s and 90s.
• Finally, Japan has seen a comparatively weak recovery from the Covid pandemic, which puts further pressure on it and makes it more difficult to deal with all the other above mentioned issues:

Conclusion

For most people, it is hard to imagine that one of the major economies could witness a hyperinflation. The majority thinks that it can only happen in banana republics and mismanaged countries. I believe that all countries are heavily mismanaged. I further believe that our financial system is fundamentally flawed — just as the Terra & Luna pegging — and that it is very erroneous to trust central banks to ‘manage’ the economy. Looking at historic evidence (all centrally controlled forms of money have failed), should at least trigger people to contemplate the idea that maybe the money supply should not be managed by authorities.

From a financial perspective, Japan is definitely in a very precarious situation. And as we have seen with the Luna & Terra collapse, once the trust is lost and panic sets in, things can rapidly spin out of control. In this scenario, there will be enormous pressure on the yields to shoot up, as the currency further declines. If the JCB wants to defend the yield curve and purchase an unlimited amount of bonds, then we might see a LUNA event.

How likely is such a scenario? Well, it depends on many factors and there are many things that could happen around the world that could impact these developments.
But I wouldn’t rule it out.

For my part, I try my best to adhere to my understanding of economic principles. And the economist, who I admire the most for his work in building a coherent economic framework, is Ludwig von Mises. In his book ‘Human Action’ he makes the following assessment:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

— Ludwig von Mises (Human Action)

What this quote suggests with regards to Japan’s monetary policy, is that the ONLY way to prevent a prolonged very high inflation — or hyperinflation — is to stop the credit expansion. This would mean to abstain from the yield curve control and let the rates rise to whatever level the market will put them.

Of course, this would lead to a severe economic collapse, with bankruptcies and suffering. But it would probably be the better solution in the long run.